Moral Hazard, Moral Hazard, and Moral Hazard

Everyone is writing a Lehman anniversary post these days, and ours is up as our weekly Washington Post column. Our topic is the many forms of moral hazard involved in the banking business these days – for employees, shareholders, and creditors – and whether or not the proposed regulatory reforms will be up to the task of dealing with the problem.

By James Kwak

22 responses to “Moral Hazard, Moral Hazard, and Moral Hazard

  1. Lavrenti Beria

    Anyone truly interested in understanding the Lehman debacle needs to read Mike Whitney at CounterPunch today:

    http://www.counterpunch.org/whitney09152009.html

    It’ll give you a new perspective on why no help was provided to commercial paper markets earlier than it was.

  2. It’s only a hazard until it’s realized. And, it’s been realized.

  3. Well, look at what is going on with Citi. They’ll entertain an idea to reduce the government stake in the bank, but still let them issue guaranteed debt? What is that supposed to communicate?

  4. It’s not supposed to communicate anything because you weren’t supposed to notice.

  5. Curious that they quote liberally from the Bloomberg article, but somehow manage to leave out the role of State Street? Was State Street cutting off Reserve Primary’s credit not the real cause for the seizure? All that was needed was to backstop Lehman, RP, or State Street, no? Too simple? Wrong?

  6. Alan Meltzer, someone who knows a thing or two about running central banks, thinks that you can do these things but you have to give plenty of notice to bankers that that’s how it will be i.e. give them a chance to adjust, and then make sure you follow through with what you say you’re going to do.

    http://www.econtalk.org/archives/2009/02/meltzer_on_infl.html

    Bernake seemed to be following Bagehot’s advice to keep people guessing (at least for a while there after Lehman) as a way of keeping them in line. Now no one is guessing and it would probably be best if he switched over to Meltzer’s approach.

  7. One might also be interested in Meltzer’s perspective on regulating the banking system now:

    http://www.tepper.cmu.edu/facultyAdmin/upload/url6_865759879210_Reg_ref_and_fed_res.pdf

  8. There are certain facts raised in this article that I feel bear repeating:

    1.) Bernake could have propped up commercial paper before TARP if he had wanted to, like he did afterwards;
    2.) American taxpayers are/were lied to and bilked.
    3.) Lehman could have been unwound neatly;
    4.) It should have been forseeable that abandoning 30 years of policy abruptly without notice might cause a some panic;
    5.) When you look at who lost and who gained, and you look at all the backroom dealing that occured during this time, and the rushed way it all happened (seemingly during each and every weekend), it’s not hard to draw your own conclusions.

  9. The banks will never approve of ANY regulations you want. The only way those regulations will pass is if the banks approve of it. The banksters are running the show and have made the situation quite clear: they WILL make money for the folks at top alone. Everyone else can eat cake.

  10. Definitely a Marie Antoinette moment in our history, where a select few within the power elite take from the rest of us to support their addiction to greed (and the power that supports it). The piper will be paid, because at this moment their are lots of issues yet to be resolved that the government can’t cope with and continue to provide the financial elite what they want. For starters we have a serious and becoming more serious problem with the environment (cures will violate the energy oligarchs strivings), health care (cures will violate the health insurance and health care oligarchs), not to mention the growing commercial foreclosures (and residential) which continue to poison the financial waters, and the state and local budgets which are being destroyed by a dramatically reduced tax base (all sales, property and income tax bases are taking big hits).

    Who is going to pay? Who knows? All of us probably, including the oligarchy in the long run.

  11. Hi Uncle Billy,

    It looks as though State Street quit honoring redemption of Reserve Primary shares at one point. Why is undisclosed. Reserve Primary has described the problem at the time as “operational”. I think claims had been made on roughly half the fund’s assets. Here are a couple of links that will offer you some but almost certainly not all of the facts:

    http://www.brisbanetimes.com.au/business/world-business/sleepatnightmoney-lost-in-lehman-lesson-20090910-fhw4.html

    http://www.brisbanetimes.com.au/business/world-business/sleepatnightmoney-lost-in-lehman-lesson-20090910-fhw4.html

    It would seem that if support were given to Lehman –
    backing up its commercial paper, for example, and that clearly a capability of Bernancke’s at the time – the crisis might have been averted. Whitney asserts that this step was not taken, and purposely, at the time so as to deepen the sense of emergency and make pressure on Congress for TARP more convincing. TARP then became largesse for the Paulson/Bernancke Christmas card list.

  12. Or, instead of having public policy be subject to analysis and judgments of all the intricacies of moral hazard we might hope for and work towards theoretical change that may lead to neutral macro economic indicators that help prove when and what sort of economic balancing is needed…
    Note that even if this were possible tomorrow, the need for regulation would remain and resisting, avoiding or ignoring this reality just seems stupid…. Devaluing the ‘hand that feeds you’ is debasement of your very own…unless people in financial power don’t care at all (maybe because their lives are based on meaningless demoralized single minded self-serving purposive materialism? (Keynes explained that financiers engaged in ‘financial machinations’ – which really does not sound meaningful) and because they have already shifted the source of their grazing to other nations. (as we recently learned)

    as a follow-up to the little article on Kindle complexities, just in case all this late night verbal venting is worth more than the usual 2 cents….
    © MC Morley :)

  13. Damn!!! I goofed again!!! Another one of my social faux pas!!! I forgot to send a thank you card to Phil Gramm of Texas!!! And I suppose if I send one to Phil Gramm I’ll also have to send a thank you card to Jim Leach of Iowa, and Thomas Bliley of Virginia…….. I sigh at the mundane little acts of courtesy required of a gentleman.

    I hope James and Simon will remind me next year so I don’t slip-up again.

  14. Yup. They are objectively antisocial. Pure sociopaths. Anyone who thinks the existing cadre can ever again play a constructive social role is as delusional as Obama if he really thinks he can work with Republicans.

    There can never be any mutually beneficial compromise between society and the finance or health insurance cadres. They’re congenitally incapable of it. That’s why “regulation” while leaving the system fundamentally intact will never work.

    The choices are to roll over and submit to eternal expropriation by this handful of entrenched feudalists, or blast them out once and for all.

  15. as it at Slate’s Money Talks that I heard yesterday that the health insurers suffer from falling revenue? i.e. that they can’t be the villains you all consider them to be.
    I do not believe it but if it is said then there must be figures out there supporting the view

    btw it doesn’t take a Winston Churchill to “adjust” a statistic, every cubicle girl helping with a power point gets quite savvy at creating false impressions albeit in a small way

  16. I’ve been thinking a fair bit about this, and Obama’s speech yesterday… and I think I know what happened.

    There was a plan, and it went off the tracks. The plan was to get Health Care done in August, and finalized/passed by early September. Tie a pretty bow on it.

    THEN, use the anniversary of Lehman to refocus national attention on financial reform, and reignite public passion on that issue with a major speech. (But, coming on the tails of an address to the joint session of Congress, the second speech was almost entirely ignored. It’s quite possible that the joint session was originally intended for financial regulatory reform before Health Care hit the skids.)

    So now I’m somewhat wondering how much of the morass we now have is due to tactical errors in timing of legislation and the failure of the administration to push its own legislation instead of making vague demands on Congress…

    vs. certain individuals in the Obama administration (especially Larry Summers) who fundamentally disagree with Simon Johnson on the proper source of / response to this crisis.

    Which is odd because the Larry Summers of 2000 seems like a rather different figure than the Larry Summers of 2008…

    http://wallstreetpit.com/9848-larry-summers-financial-crises-result-from-fundamental-problems-that-should-be-fixed (good article, in spite of the author… ;)

    vs.

    http://www.clipsandcomment.com/2009/03/13/full-text-larry-summers-speech-brookings-institution-the-obama-program-and-the-current-economic-crisis/

    It’s not that the second speech is necessarily wrong; but it is very different. The first speech, for example, DOES focus somewhat on the Moral Hazard problem (among others). The second speech (2008) focuses more on a littany of structural problems with the US economy.

    The second speech seems to implicitly argue that the world economy/financial system is in fact a Spinning Top that was starting to slow down (and nearly toppled over). Priority 1 was get it spinning again at all costs.

    What strikes me about the second speech is this quote:

    “One of the most important lessons in any introductory economics course is that markets are self-stabilizing…”

    “…However, it was a central insight of Keynes’ General Theory that two or three times each century, the self-equilibrating properties of markets break down as stabilizing mechanisms are overwhelmed by vicious cycles.”

    If you take this perspective to it’s logical conclusion, the results are:

    The best of all possible systems is a relatively unrestrained free market, but 2 or 3 times a century we’re going to have a cyclical de-leveraging “avalanche” and the government needs to prop up the economy. That’s just the way things are.

    Summers furthermore says: “Instead of an expectation of new buyers, there is an expectation of new sellers. Greed gives way to fear. And this fear begets fear… This is the paradox at the heart of the financial crisis. (original text was bolded)”

    Understand what he is saying: the core problem is investor psychology. This speech was delivered in spring of 09, so he’s had 6 months to think about this. And the core problem is psychology… What’s more, the government’s _best response_ to this obvious failure of the Efficient Markets Hypothesis is to nothing until the crisis, then step in with massive liquidity.

    Now I’ve grumbled that Baseline is a little _too_ obsessed with Too-Big-To-Fail and Moral Hazard, but here we have Larry Summers on the absolutely other end of the spectrum.

    If Summers truly believes that the CORE problem is psychology, that the best of all possible systems is relatively unrestrained free markets that will seize up 2-3 times a century, that the government’s best response is to intervene generously…

    Well, sufficeth to say that Larry Summers is Obama’s economic Brain, and he clearly has no Heart for real structural reform and regulation of the financial sector.

  17. just checked it:

    Larry Summers is born in 1954 that makes him 12 years my junior but the way you quote his take on psychology I was immediately reminded of our madness of the early 70s when we would find a psychological reason (fault) for everything from cancer to getting hit by another car. Always we found a deep hidden wish for calamity which turned the victim into the perpetrator

    Ever since I left that mad way of thinking behind I feel sure that when some official starts elaborating on psychology that there are some solid facts I am not supposed to know about.

    as to Larry Summers begin 12 years my junior either those so much younger went for the same madness as we older ones did or he is using arguments he knows appeal to us in our 60s who are still in love with psychobabble and judging from the media there is still a lot of blaming it all on potty training around.

  18. All of his talk is a cover for taking from the poor to give to the rich.

  19. I assume you mean an unrestrained free market for monopolized capital. Two or three times a century? Let’s see: 1907, 1921, 1929, 1930, 1961, 1970, 1982, 1987, 1997, 1998, 2000, 2001, 2008. I think you will find most of the unrepresented periods involved highly profitable wars. What your unrestrained free market creates is asset bubbles fueled by debt. Individuals stay afloat as best they can by taking on debt. The crash comes, the banks are saved with free government money, but the individuals who are under water are liquidated in bankruptcy. No doubt you see this as healthy? Don’t think I’d enjoy being one of them, though. Your man Larry Summers, in August 2008, delivered the perfect judgment upon himself: what he said (in the Harvard alumni magazine) was that financial services has done a great job of taking capital from those who are unable to use it themselves and moving it to those who use it well. I believe this is just before the Harvard endowment began melting down under his stewardship as university president.

  20. “taking capital from those who are unable to use it themselves and moving it to those who use it well. ”

    what a truly socially beneficial attitude because, as everybody knows, the great unwashed cannot be trusted to spend their money wisely.

    and what a brillant redefinition of why North Italian merchants originally pooled their capital to make sending ships around the Mediterranean less of an individual risk

  21. I do not think I am defending Larry Summers… Rather, I’m noting that Mr. Summers’ economic views tend to be somewhat schizophrenic.

    As to the Harvard Endowment, I do believe most investment funds would have loved to have the returns the endowment generated (even with the recent plummet). Averaged over time, it quite outperformed the major indices and most other institutional investors.

    http://www.hbs.edu/about/annualreport/2008/gifts3.html

    (This next graph counts new contributions, but even so rather impressive.)

    Moreover, the plummet occurred after Larry Summers’ ill-fated reign.

  22. Yound Economist

    FED is going to create the speculative bubble in the economy and financial market by using too low interest rate and this bubble will be like subprime crisis. We will have bubble that is from wrong resource allocation from too low interest rate and we also will have the crisis that will cause the shock on economy and labor market.

    I think it is very wrong policy is the main reason for the higher unemployment rate and higher cost of living currently. FED support speculators on Wall Street, mainly financial institution, to push up asset price and inflation too high and then FED have very slow reaction on the speculation; therefore, we have big bubble and speculation and big crash and crisis.

    This policy still goes on by Bernanke and it will cause the bigger crash and crisis but we have the same result that is the higher unemployment. Now FED lie everyone about inflation trend and the effect of monetary policy on the welfare (lower cost of living (low inflation) and lower unemployment). The inflation is currently low due to the base effect that oil price was too high last year but the current inflation trend is too high. The monthly inflation show the growth at 6% , ISM price paid show the jump in core inflation, and if we pass this October, the inflation will go to around 3-6% in the next six months (oil price is at this level) and core inflation will move up to 2-4%. Therefore, we are going to have higher inflation than the past cycle and inflation will move up more quickly than the past cycle.

    Another FED’s lie is the monetary policy can improve the unemployment rate. Greenspan and Bernanke used too low interest rate after Tech bubble and create short term speculative economy with high property and asset prices, higher consumption but we have no real economy, no real employment and our businesses have no competitiveness. Frankly, GDP can grow but we have the worst employment in the every cycle because when we use too low interest rate, it will push up price higher and more quickly. Business can have more profit from higher margin and they have no need for new investment because there is no real demand increase. I call the Monopoly support by FED. Then, when speculators get too cheap funds from FED, they put into asset speculation, surely, it makes people believe that we had the good economy because stock prices went up, real estate price went up. But we were just in the speculative economy that FED created.

    All FED policy that keep interest rate too low and unrealistic and the more FED try to push economy to Monopoly and Speculative economy, the more severe effect of crisis and crash will occur and surely we all know that this policy create more volatile economy and less people going to real investment that need long term return rather than short term return in financial markets. It is going to create the less real economy and the less real employment.

    I think, after this October, inflation will go up uncontrollably to 6% in six months and we will have big bubble and big crash by itself and surely, unemployment rate will move up more than anyone expects. So, FED should stop the speculation and stop lying on their policy and economic and inflation forecast.

    I think before regulating the bank, we should have the law to regulate FED and government to use monetary and fiscal policies for long term and sustaining growth rather than for speculators like this.