MORAL HAZARD.

MORAL HAZARD. In this article, James Surowiecki explains some of the difficulties in attempts to reduce moral hazard. An example he gives is that people who buy fire insurance may not be as careful about preventing fires at their houses. (I posted here about the proposal by economists to reduce accidents by forbidding safety belts for drivers and installing a large spike in the center of the steering wheel). If financial institutions expect that they will be bailed out by the government, they will take more risks because taxpayers will take the loss. Surowiecki points out that although there were objections to the first bail out of an investment bank (Bear, Stearns), by the time it was bailed out, its shares had fallen almost 95% from the previous year. Surowiecki suggests that 95% is enough punishment. Lehman Brothers was not bailed out. Surowiecki concludes that “the failure of Lehman Brothers was an unnecessary and costly sacrifice to moral-hazard fundamentalism.” I have always thought that Bear Stearns had taken a big enough hit to send a message and that the most important issue was what was the best way to unwind the toxic Lehman Brothers investments.