What Ever Happened to Moral Hazard?

The term "moral hazard" has a long history, but it was brought into prominence by economist Kenneth Arrow to describe situations in which governments step in to rescue private financial institutions from the consequences of their own risky or imprudent behavior. The term itself has an interesting etymology; hazard was originally a dice game, like craps, in which bettors would often wager (and lose) their fortunes, which, come to think of it, is really not that different than banks making disastrous bets on subprime mortgages, credit default swaps, toxic assets and the other forms of financial chicanery that caused the financial meltdown in September 2008 and let to a global recession that is still not over.

The word "moral" also did not necessarily have to do with ethical evaluation and accountability as it does today. According to Martha C. White, "moral hazard was an assessment of risk based on the situation. For instance, a log cabin was more susceptible to fire damage than a stone cottage. Over the years, though, “moral hazard” also came to mean a situation in which the insured became cavalier about due diligence on their end—leaving a cooking fire unattended in that log cabin, for instance—banking on restitution in the event of a disaster" [Martha C. White (2008) . What is a Moral Hazard? From Slate - The Big Money].

The basic idea of moral hazard as we use the term today is that people and institutions will be encouraged to take greater risks than they should or otherwise would if they believe that someone else will take responsibility for rescuing them if things turn out really badly. For instance, the government, an insurance company, or bleeding heart liberal do-gooders will step in to save people from the worst consequences of their own irresponsible behavior. If the government has a track record of stepping in to rescue banks that are "too big to fail" from the consequences of their own greed and poor judgment, this creates a moral hazard that encourages future risky behavior on the parts of bankers.

This outcome is particularly likely, many people believe, if those who were rescued in the past are not forced to accept any of the costs of their own bad behavior and, moreover, are rescued without agreeing to accept any new regulations that would prevent them from making similarly poor choices in the future. This sort of governmental response to a financial crisis rewards irresponsible behavior by privatizing the profits while socializing the costs. It is a perverse incentive that encourages irresponsibility.

This is just what the US government did last fall in response to Wall Street's bad bets and the collapse of credit markets. Many people, including myself, accepted the argument at the time that, although a massive government bailout could indeed create moral hazards, this risk was insignificant compared to the very real and immediate risk of a panic that would trigger an economic depression. In doing so I had assumed that eventually we would start addressing the risk of moral hazard and do something to re-regulate the financial industry in order to prevent the banks and insurance companies that were rescued from engaging in the very kinds of risky investments that got them, and all the rest of us, into this mess. Whatever happened to that?

What happened is that financial re-regulation got put on Obama's back burner and no one is talking about it any more. Now people are talking about a "government take-over" of health care insurance. The language of "take overs" is important, because the idea resonates with something a lot of people object to about the way the government has handled the financial crisis, the recession, the failures of GM and Chrysler, and yes, even the "Cash for Clunkers" program that is due to expire tomorrow.

In each of these cases it appears that government intervention undermines the value of personal responsibility. Steeped in the Protestant Ethic of self-reliance and independence, there are many American's whose sense of morality is offended when they think that the government, or indeed anyone else, is planning to "take over" matters that should properly be one's own business. Adults are supposed to take care of themselves and it is an affront to one's dignity to have the government involvement in what should be a matter of personal responsibility. The term "take over" also connotes loss of control, so the term delivers a double-whammy to people who fear that the government is trying to run their lives.

Obama and his advisors would do well to recognize this and to start re-framing the national debate over health insurance reform to highlight the need for greater personal responsibility in matters of health. They should hammer on this theme whenever they talk about the way health insurance works in this country. What we really have is "sick care" rather than health care. People with health insurance are not necessarily encouraged to stay healthy by, for instance, joining a gym, stopping smoking, losing weight, getting regular physicals, engaging in wellness programs, eating healthier foods, and so forth. Rather, they are paying for the assurance that that when they get sick or are injured someone will help them pay their medical bills.

The so-called "public option" (a terrible name) needs to be described as a low-cost form of health insurance that will create incentives for people to get primary medical care, engage in personal behaviors that encourage wellness and disease prevention, pay doctors and hospitals for keeping people healthy rather than treating them when they get sick, and employing the best evidence-based treatments available in a coordinated and efficient manner. It should be called something like "WellCare" or "Amerihealth" to give it the right vibes. Above all the pitch should emphasize that it is not a substitute for individuals taking personal responsibility for their own health. Rather it will operate so as to make it easier for folks to do so by creating positive incentives that will lead to better health outcomes and lower costs for everyone.

The outstanding success of the "Cash for Clunkers" program demonstrates that even proud and independent-minded Americans are not averse to accepting government help in doing what they should be doing for themselves anyway. "Sure," they will say, "I probably made a mistake when I bought that Ford Expedition ten years ago, never expecting that the price of gasoline would go over $4.00 a gallon." "But, I am damn happy to accept a government check for $4500 to trade it in for a Toyota Corolla. If the banks can get billions why can't I get a few thousand?" The moral hazard here, that people will continue to make stupid consumer decisions expecting that the government will bail them out, is not so serious, and most of us will just shrug our shoulders and accept the risk.

But what about the people who never bought an SUV in the first place, or who never smoked, who exercise regularly, eat fresh healthy food, invested their money prudently and cautiously, and generally accepted personal responsibility for taking good care of themselves? What are we getting? We are getting screwed. We did the right thing, after all, and accepted our personal responsibility and also some share of our social responsibilities. We could at least get a little credit, you know.

There is, in fact, no contradiction between accepting personal responsibility for caring for oneself, and also accepting a share of social responsibility for caring for others. Generally speaking, living a life of personal responsibility is an achievement for which individuals can be justly proud. Living such a life is also, generally speaking, a precondition for accepting one's social responsibilities, particularly those that involve caring for others. Accepting the burdens of parenthood and raising children is the primary way in which most adults express their social responsibility, their willingness to make sacrifices for the good of others. This is fine and good, and responsible parents should get a lot of credit.

Some individuals extend their social responsibility beyond the confines of their own family, and accept some responsibility for fixing some of the "big problems of society". Such people manifest a higher virtue by voluntarily "taking responsibility" for helping to "repair the world", but those who stop at personal responsibility and familial responsibility are not to be faulted on that account. These folks understand that by taking care of themselves and their loved ones, they are doing a good service to society by not having to ask anyone else for help in what should properly be their own responsibility.

These folks don't get enough credit; we should let them know that by caring well for themselves and their families they are fulfilling their primary social responsibilities. But, they might also need to be reminded that their are lots of folks who are not so fortunate, who for one reason or another, mostly not because of their own choices and actions, are unable to fully take care of themselves and for minor children who depend on them, and could use some help getting to a position of self-reliance. Framed in this way, most people will respond with compassion rather than with scorn or indifference. Particularly if one invokes the principle of reciprocity (popularly known as the Golden Rule) and proposes that they themselves should be entitled to similar help if ever they falter and cannot fully take care of themselves. We humans are wired for reciprocal altruism; we just have to figure out how to activate these responses when mutual aid is mediated by large governmental institutions.

If people take personal responsibility for themselves, and accept a fair share of their social responsibilities, they should be lauded and indeed rewarded for doing so. The problem, once again, is one of perverse incentives. We are embracing policies that discourage people from taking personal responsibility when we should be doing the opposite. The idea that our major institutions should be incentivizing and rewarding both personal and social responsibility is a winner both politically and morally.

So why don't more politicians get it?

Addendum 9/12/09: This New York Times story explains what happened to the idea of moral hazard in the financial industry. It morphed into I.B.G.