moral hazard Archives - the patient investor

April 13, 2014

Disturbing trends with financial crises

From the Economist:

Five devastating slumps—starting with America’s first crash, in 1792, and ending with the world’s biggest, in 1929—highlight two big trends in financial evolution. The first is that institutions that enhance people’s economic lives, such as central banks, deposit insurance and stock exchanges, are not the products of careful design in calm times, but are cobbled together at the bottom of financial cliffs. Often what starts out as a post-crisis sticking plaster becomes a permanent feature of the system. If history is any guide, decisions taken now will reverberate for decades.

This makes the second trend more troubling. The response to a crisis follows a familiar pattern. It starts with blame. New parts of the financial system are vilified: a new type of bank, investor or asset is identified as the culprit and is then banned or regulated out of existence. It ends by entrenching public backing for private markets: other parts of finance deemed essential are given more state support. It is an approach that seems sensible and reassuring. But it is corrosive. Walter Bagehot, editor of this newspaper between 1860 and 1877, argued that financial panics occur when the “blind capital” of the public floods into unwise speculative investments. Yet well-intentioned reforms have made this problem worse.

…..To solve this problem means putting risk back into the private sector. That will require tough choices. Removing the subsidies banks enjoy will make their debt more expensive, meaning equity holders will lose out on dividends and the cost of credit could rise. Cutting excessive deposit insurance means credulous investors who put their nest-eggs into dodgy banks could see big losses…..

Read more at Financial crises | The Economist.

March 20, 2013

Unintended consequences: Rewarding failure

Robert Shiller summarizes the arguments for raising taxes and increasing government spending at Project Syndicate:

……while that [austerity] approach to debt works well for a single household in trouble, it does not work well for an entire economy, for the spending cuts only worsen the problem. This is the paradox of thrift: belt-tightening causes people to lose their jobs, because other people are not buying what they produce, so their debt burden rises rather than falls.

There is a way out of this trap, but only if we tilt the discussion about how to lower the debt/GDP ratio away from austerity – higher taxes and lower spending – toward debt-friendly stimulus: increasing taxes even more and raising government expenditure in the same proportion. That way, the debt/GDP ratio declines because the denominator (economic output) increases, not because the numerator (the total the government has borrowed) declines.

What he does not consider, however, is the message we are sending to government. In much the same way as bailouts increase moral hazard — with too-big-to-fail institutions taking on bigger risks secure in the knowledge that the taxpayer will bail them out if the bets don’t pay off — we encourage bad behavior from politicians if we allow them to raise taxes and increase government spending every time they screw up the economy. Federal government spending in the US economy has grown from 12.5% of GDP in 1950 to nearly 25% of GDP today. Seems like they are getting the wrong message.

Federal Spending as % of GDP

That is like giving someone a promotion or a raise every time they mess up. When politicians fail, they need to get the right message — and not only at the next election. Cutting budgets when the economy is in recession is the right response, but how can we achieve this while saving the economy from a deflationary spiral?

The only way I can think of is to cut taxes and government expenditure, but encourage private investment in productive infrastructure through Treasury-backed low-interest or even interest-free development loans. These could be administered by an independently-elected infrastructure body with representatives from all parties. There are dangers, and the process would have to be closely monitored, but the risks are minor compared to rewarding failure.

December 6, 2011

The euro zone’s terrible mistake | Felix Salmon

The FT is reporting today that the new fiscal rules for the EU “include a commitment not to force private sector bondholders to take losses on any future eurozone bail-outs”……The immediate result of this plan is that everybody will rush into the highest-yielding bonds in Europe, which is exactly what seems to have happened today……In order for markets to work, lenders need to suffer when they make bad lending decisions. If the Europeans didn’t learn from Ireland, couldn’t they at least learn from the Fed’s much-criticized decision to pay off all AIG creditors at 100 cents on the dollar? Blanket guarantees at par are pretty much always a really bad idea — and this one, if it comes to pass, will be the biggest one yet.

via The euro zone’s terrible mistake | Felix Salmon.

Colin Twiggs: ~ More evidence of moral hazard: giving bond-holders an effective put against the EU. Perhaps a partial guarantee (e.g. 90 percent) would be more effective in containing moral hazard as the bond-holder still has some skin in the game.