SKOPJE, Macedonia, May 31 (UPI) -- Established economic theory pioneered by Nobel prizewinner Robert C. Merton in 1977 shows that, counterintuitively, the closer a bank is to insolvency, the more inclined it is to risky lending. Nobuhiko Hibara of Columbia University demonstrated this effect convincingly in the Japanese banking system in his November 2001 draft paper titled "What Happens in Banking Crises -- Credit Crunch vs. Moral Hazard."
Last but by no means least, as opposed to oft-reiterated wisdom the markets have no memory. Russia has egregiously defaulted on its sovereign debt a few times in the past 100 years. Only four years ago, it thumbed its nose with relish at tearful foreign funds, banks, and investors.
Yet, it is now besieged by investment banks and a horde of lenders begging it to borrow at concessionary rates. The same goes for Mexico, Argentina (last time, not yet this time, but soon) China, Nigeria, Thailand, other countries, and the accident-prone banking system in almost every corner of the globe.
In many places, international aid constitutes the bulk of foreign currency inflows. It is severely tainted by moral hazard. In a paper titled "Aid, Conditionality and Moral Hazard," written by Paul Mosley and John Hudson, and presented at the Royal Economic Society's 1998 Annual Conference, the authors wrote:
"Empirical evidence on the effectiveness of both overseas aid and the 'conditionality' employed by donors to increase its leverage suggests disappointing results over the past thirty years ... The reason for both failures is the same: the risk or 'moral hazard' that aid will be used to replace domestic investment or adjustment efforts, as the case may be, rather than supplementing such efforts."
In a May 2001 paper, tellingly titled "Does the World Bank Cause Moral Hazard and Political Business Cycles?" authored by Axel Dreher of Mannheim University, he responds in the affirmative:
"Net flows (of World Bank lending) are higher prior to elections ... It is shown that a country's rate of monetary expansion and its government budget deficit (are) higher the more loans it receives ... Moreover, the budget deficit is shown to be larger the higher the interest rate subsidy offered by the (World) Bank."
Thus, the antidote to moral hazard is not this legendary beast in the capitalistic menagerie, market discipline. Nor is it regulation. Nobel Prize winner Joseph Stiglitz, Thomas Hellman, and Kevin Murdock concluded in their 1998 paper -- "Liberalization, Moral Hazard in Banking, and Prudential Regulation":
"We find that using capital requirements in an economy with freely determined deposit rates yields ... inefficient outcomes. With deposit insurance, freely determined deposit rates undermine prudent bank behavior. To induce a bank to choose to make prudent investments, the bank must have sufficient franchise value at risk ... Capital requirements also have a perverse effect of increasing the bank's cost structure, harming the franchise value of the bank ... Even in an economy where the government can credibly commit not to offer deposit insurance, the moral hazard problem still may not disappear."
Moral hazard must be balanced, in the real world, against more ominous and present threats, such as contagion and systemic collapse. Clearly, some moral hazard is inevitable if the alternative is another Great Depression. Moreover, most people prefer to incur the cost of moral hazard. They regard it as an insurance premium.
Depositors would like to know that their deposits are safe or reimbursable. Investors would like to mitigate some of the risk by shifting it to the state. The unemployed would like to get their benefits regularly. Bankers would like to lend more daringly. Governments would like to maintain the stability of their financial systems.
The common interest is overwhelming and moral hazard seems to be a small price to pay. It is surprising how little abused these safety nets are as Stephane Pallage and Christian Zimmerman of the Center for Research on Economic Fluctuations and Employment in the University of Quebec note in their paper "Moral Hazard and Optimal Unemployment Insurance."
Martin Gaynor, Deborah Haas-Wilson and William Vogt cast in doubt the very notion of "abuse" as a result of moral hazard in their NBER paper titled "Are Invisible Hands Good Hands?":
"Moral hazard due to health insurance leads to excess consumption, therefore it is not obvious that competition is second best optimal. Intuitively, it seems that imperfect competition in the healthcare market may constrain this moral hazard by increasing prices. We show that this intuition cannot be correct if insurance markets are competitive.
A competitive insurance market will always produce a contract that leaves consumers at least as well off under lower prices as under higher prices. Thus, imperfect competition in healthcare markets cannot have efficiency enhancing effects if the only distortion is due to moral hazard."
Whether regulation and supervision -- of firms, banks, countries, accountants, and other market players -- should be privatized or subjected to other market forces, as suggested by the likes of Bert Ely of Ely & Co., in the Fall 1999 issue of The Independent Review, is still debated and debatable. With governments, central banks, or the International Monetary Fund as lenders and insurer of last resort, there is little counter-party risk.
Private counter-parties are a whole different ballgame. They are loath and slow to pay. Dismayed creditors have learned this lesson in Russia in 1998. Investors in derivatives get acquainted with it in the 2001-02 Enron affair. Larry Silverstein is perhaps being agonizingly introduced to it in his dealings with insurance companies over the Sept. 11 World Trade Center terrorist attacks.
We may more narrowly define moral hazard as the outcome of asymmetric information and thus as the result of the rational conflicts between stakeholders (e.g., between shareholders and managers, or between "principals" and "agents"). This modern, narrow definition has the advantage of focusing our moral outrage upon the culprits rather than, indiscriminately, upon both villains and victims.
The shareholders and employees of Enron may be entitled to some kind of safety net, but not so its managers. Laws and social norms that protect the latter at the expense of the former, should be altered post haste. The government of a country bankrupted by irresponsible economic policies should be ousted -- its hapless citizens may deserve financial succor. This distinction between perpetrator and prey is essential.
The insurance industry has developed a myriad ways to cope with moral hazard. Co-insurance, investigating fraudulent claims, deductibles and incentives to reduce claims are all effective. The residual cost of moral hazard is spread among the insured in the form of higher premiums. No reason not to emulate these stalwart risk traders. They bet their existence of their ability to minimize moral hazard -- and hitherto, most of them have been successful.
Part 1 of this analysis ran Thursday. Send your comments to: [email protected]
