Thursday, February 19, 2009

We Worry Too Much About Moral Hazard

James Surowiecki has a good post on how we overemphasize the risk of moral hazard. Even the classic case of moral hazard turns out to be unsupported; people who are insured often have fewer accidents, not more.

Surowiecki identifies three reasons why this is so. The first is it’s often unclear if a bailout will occur and on what terms. It’s unlikely people rely on a safety net if it may not be there.

Secondly, when we’re talking about the actions by companies like banks, it’s more likely that the risks they take are driven by individual decisions, and not the interests of the institution itself. Trader and banker incentives, not moral hazard, is the issue.

Here’s Surowiecki on the final reason:

Finally, the biggest reason that moral hazard matters less than it might is that it can operate only if people actively countenance the possibility that their decisions could lead to complete disaster. But it’s well documented that people generally, and investors particularly, are overconfident and significantly underestimate the chances of being wiped out. The moral-hazard fundamentalists argue that banks and other financial institutions will act recklessly if they think they’ll be rescued in the event of failure. But Wall Street was reckless because it never believed that failure was even a possibility.