An ideological battle has been going on in America – not the historical battle from the 1960s of communism versus capitalism – but, rather a battle between those who seek to sustain market fundamentalism as a credo, and those who believe that regulation of financial markets will help reduce the tendency toward moral hazard. It has been argued by Joseph Stiglitz in his recent book Freefall (2009) that the excesses of deregulation led to the need for the Toxic Asset Relief Program (TARP) and other Federal bailouts after the sharp drop in the stock markets and freeze-up of the global credit markets in 2008/2009. Further, he argues that programs like these and the “too big to fail” policy framework increased the tendency toward moral hazard, rather than reduced it.
Economists use the term “moral hazard” to indicate a situation in which one party in a transaction has more information than another leading to what is called “information asymmetry. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information. In the US case, bankers, such as those involved in the recent Goldman Sachs controversy had more information, and clients and the general public, had less information. So when Goldman Sachs began to hedge against the risk of market collapse and didn’t bring their trusted clients along, their actions demonstrated moral hazard.
The actions of various parties during the sudden drop in the stock markets that are culpable all along the blame chain would seem to indicate moral hazard. Each participant along the way in the mortgage lending crisis was acting in a rational manner but the highly deregulated framework did, indeed, give rise to moral hazard all along the way. Taxpayers, now burdened with the ballooning debt from the various bailouts for banks and auto companies don’t necessarily connect the dots between the idea of deregulation, unemployment in the US, the widening of the gap between the very, very wealthy and the growing numbers of poor, cash-strapped state and local governments, and uncertainty about the future. But these dots should be connected.
The actions of individuals in the US during the sub-prime mortgage market-induced world-wide recession have had global impacts. These actions were all rational at the time and were based on best information. Individuals were all incentivized to ‘game’ the system to act in their own best interest. The problem was that the policies were all devised within the context of market fundamentalist rhetoric which called for deregulation of the financial sector.
By combining the ideological framework of a deregulated financial sector with the high rates of consumption of American consumers in the 1990s and early 2000s and we had a disaster in the making. Consumption was financed in large part from draws on the perceived (growing) value of assets (i.e., homes), and not from income. Therefore, when the value of the assets went down, the bubble burst, it left a lot of people underwater, not only on their homes, but also on their credit card debt.
But the vehicle upon which that easy money was based was induced by low interest rates (set by the Federal Reserve Bank, the herald of free market fundamentalism). It was exacerbated by more and more complex forms of securitization of subprime loans. The loan originators had a financial incentive to generate more and more loans, which, in effect, became riskier and riskier. These loans were often Adjustable Rate Mortgages (ARMs) that had big balloon payments after a specified number of years. Many of the borrowers could not make those payments and, therefore, had to walk away from their homes. The banks had a financial incentive to securitize, or package, these loans and pass them on to investors. Ratings agencies were also culpable in that their risk models did not include a way to characterize the synergistic effect of simultaneous failures in the financial system. In truth, there were many small moral hazards that all added up to one huge moral hazard for all of us.
All of the rational actors along that way were maximizing their benefit based on best available information. The aggregate effect of this, especially in light of the budget cuts for education, health care, foreign aid and other socially desirable outcomes, has been to make the world a more impoverished, resource-depleted, and dangerous place to live. One would think that, after the fallout from the failed policies of the market fundamentalists, that there would be little political support for continued efforts along those lines. However, complex ideologies die hard. We’ll all have to watch carefully how the debates on financial reform in Congress play out. We have a moral obligation to do so.